Apple Strengthens Its Case for a Higher Multiple

Apple’s December results strengthen the case that the company deserves a higher earnings multiple.

There are currently two conventional investor views on Apple’s valuation: First, while Services have diversified the company’s business, Apple is still a “supercycle” boom and bust company, that should trade at a lower earnings multiple compared to other large tech companies given its riskier hardware business (evidence by the Dec-18 qtr when Apple missed street estimates). Under this view, investors believe Apple’s valuation is currently stretched. Second, some investors believe the company should be valued as a sum of its parts. Under this view, investors believe Apple is valued properly.

We see an emerging paradigm where investors acknowledge that the company has proven its combination of over 1.5B active devices (up 8% from last year) wrapped in software and Services can deliver reliable earnings well ahead of its peers. For example, this year Apple’s GAAP earnings will essentially equal the combined profit from Google, Microsoft, and Amazon. Despite this, investors value Apple’s market cap at $1.4T compared to the $3T market cap of the other three companies combined.

If we’re correct that investors will increasingly value earnings, the valuation gap will close. Applying a multiple similar to Google, Microsoft, and Facebook to Apple’s GAAP earnings yields an AAPL fair value share price above $400. We believe over the next 4 years, the company can consistently grow revenue at 5% and earnings at 10%. On top of the increasing importance of earnings, there’s a case that Apple should trade at a higher multiple than its tech peers given macro tailwinds benefitting the company. Apple’s business will be one of the biggest beneficiaries of a three-year lift from 5G and wearables, along with optionality value from other upcoming unannounced products.

Movements take time to become mainstream, and Apple’s December results made a statement that the company’s movement to fair value should continue.

Results

Revenue Growth Continues to Accelerate

Guidance suggests Mar-20 yearly revenue growth of 15%, up from 9% in Dec-19. If the company delivers March results near the high end of guidance, which is typical, revenue growth will have accelerated for four consecutive quarters after being down 5% in Mar-19.

Lower Priced iPhone’s Spike Demand

iPhone revenue was up 8%, well above the Street expectations of down 1%. Looking forward, guidance suggests iPhone revenue will likely be up 12% in the Mar-20 quarter. We expect similar growth in the Jun-20 quarter. Sales have been boosted by the first full quarter of iPhone 11, which is priced $50 less than its iPhone XR predecessor. We estimate overall iPhone ASPs declined to $765 from its peak of $790 a year ago. The company is likely going to continue to pursue the lower-priced iPhone theme with an updated iPhone SE later this year starting at $399.

Services Fractional Miss

The one disappointment in the quarter was the fractional miss in Service’s revenue, reporting 16.5% growth compared to the Street at 18%. Some argue the miss in higher-margin services revenue tarnishes the quarterly results. Our view is the Services growth is essentially in the range (albeit at the low-end) of growth over the past few years and continues to be a positive reliable theme for the Apple story.

Wearables Opportunity Still Untapped

We believe there is room for 20% plus wearables revenue growth over the next several years driven by both Watch and AirPods. Putting the Watch opportunity into context, we estimate the active installed base of Watches is about 72m vs the iPhone installed base of about 930m. This implies an 8% penetration of the Watch’s addressable market. For AirPods, we believe there are now 92m pairs in use, suggesting about 10% of its addressable market has been captured.

China Relatively Steady

Greater China represented about 15% of revenue in Dec-19, compared to 17% last quarter. While down slightly, it still shows the company has effectively navigated the China trade dispute.